Why Banks Won't Lend
Credit is scarce and the outlook is gloomy, so what can be accomplished in this economic environment?
Bank credit remains the essential lubricant of a free-market economy. Without it,
many firms are in for a protracted bout of "liquidity gridlock," making it difficult
and, in some sectors, impossible to fund operations. It is no secret that the financial
services industry and the broader economy hit a sharp inflection point in October,
in what can best be described as a "deflationary debt bust." In response, the U.S.
Treasury and the Federal Reserve have intervened in credit markets in manners never
before seen, applying virtually every tool at their disposal. Perhaps, this has
slowed the pace of de-leveraging in the financial markets, but it has not improved
the availability of credit.
CAPITAL IS KING
While banks have experienced relentless pressure to rein in leverage, either by
shedding assets or accumulating capital, collective leverage has actually increased
slightly among the regional northwest ("NW") banks1 and significantly for the major
NW banks2, as illustrated in the chart on the following page. Several factors have
been at play here. Aggregate assets have expanded, as customers have drawn down
outstanding commitments and securitized loans and mortgages have been moved on to
bank balance sheets. At the same time, as non-performing assets mount, loan-loss
reserves have ramped up. Collectively, over the past five quarters, the regional
banks reserved nearly $400 million, while the major banks pumped up loss provisions
by ten times that amount. Bankers acknowledge that further credit deterioration
will trigger significant additional loan-loss provisions in the coming quarters.
That expectation, coupled with the pressure to de-lever, has made bank capital very
The major banks offset the losses realized to date with $59 billion of capital injections
from Treasury's TARP program and raised another $26 billion (mostly BofA) from private
sources. The regional banks, except Frontier, also have been replenished with TARP
infusions totaling $718 million. No one has a clear understanding as to the amount
of additional losses that reside on the loan books of NW banks. Given the severity
of the recession and the yet to be fully unveiled spike in troubled assets, it is
not unreasonable to believe that before this downturn has run its course, the losses
may more than double, thereby bringing leverage ratios right back to where they
started. Reflecting these concerns, institutions have stepped up efforts to trim
commitment levels and conserve capital.
PLAN FOR THE WORST, EXPECT THE BEST
The prospect of a prolonged downturn should cause managers to take an introspective
look at their businesses to consider contingency plans for reducing costs, for selling
excess assets to free up cash, and for reassessing the rate and direction of growth.
At the same time, managers should think through the opportunities provided by a
downturn. Astute investments made during a downturn can position a company to strengthen
its competitive advantages so as to realize benefits when times improve. A downturn
can be a great opportunity to hire talent, to continue spending on strategic initiatives,
and to target accretive acquisitions.
Getting to the other side will require, at minimum, continued access to external
capital. Articles in this issue are intended to assist management in those endeavors,
so that the business can be positioned to create the maximum amount of shareholder
value when economic conditions invariably rebound.
Credit is scarce, but it begs the question, what can be accomplished in today's
environment and over the next year? We set out to nail that down in a series of
discussions with senior NW bankers to define the art of the possible. The answers
were not reassuring; but, some common themes emerged.
Fear factor. There is palpable anxiety among bankers that their institutions, and
therefore their jobs, may be in jeopardy. Nothing inhibits risk taking more effectively
than uncertainty and fear for survival.
Suddenly, relationships matter. Bankers are reticent to admit that they're "out
of the market." For good reason, it sends a message that rarely resonates well with
performing customers and major depositors. The line seems to be, "We are open to
new opportunities." In reality, the credit screen is set on "extra fine." The prime
consideration tends to be whether the prospective borrower is a customer or, at
the very least, a well-known prospect. In other words, has the credit favorably
crossed the desk of the bank's credit decision-maker in the recent past?
Every banker queried declared that they are focused on taking care of existing clients.
However, the strength of that support varies widely, depending on the bank's situation
and the specifics of the customer. Resilient, well-performing companies may have
access to additional debt, particularly if the purpose is a value-enhancing opportunity
(e.g., a conservatively priced acquisition).
Flight to quality. Bankers have become extraordinarily finicky. Assuming the relationship
test is met, the terms under which new credit may be available are a major departure
from what borrowers were accustomed to in the recent past. What little lending appetite
there is will be focused on situations that meet the following criteria:
Struggling businesses, or those in industries deemed vulnerable or over-capitalized,
are unlikely to find their bankers accommodating. The list is too long to enumerate,
but credit is particularly scarce for vehicle and equipment dealers, building products
manufacturers and distributors, travel and leisure operators, retailers, and, surprisingly,
all aspects of health care. Several bankers confessed that no one is penalized for
saying "no" in this environment, even to a compelling prospect. New business is
met with a jaundiced eye; it is no time to be cold-calling bankers.
Given the capital constraints and a dearth of acceptable lending opportunities,
banks have little prospect of lending their way out of this hole. Nevertheless,
they are energetically attacking their earnings problem by extracting fees and ratcheting-up
credit spreads, wherever possible. Risk is being repriced across the entire financial
spectrum. Even "Cadillac- quality" borrowers should anticipate paying more for credit—a
100 to 150 basis point bump for strong, modestly leveraged borrowers and a tripling,
or more, of credit spreads for leveraged firms.
- Well-supported (low advance rates) with collateral valuations reflecting the weak market for most categories of real and personal property.
- Very modest financial leverage—1 to 2 times EBITDA. Bankers related stories of passing on one-times cash flow financing opportunities for performing businesses.
- Shorter maturities. Revolving credit line expirations are being limited to 364 days, in order to minimize regulatory capital requirements. Maturities on term credit are being held to three years or less.
- A well-articulated business strategy, along with a demonstrated ability to plan and budget, and evidence of highly reliable financial systems.
Minor covenant modifications or violations are likely to garner hefty fees and,
in many cases, unravel an existing deal, with a complete revision of credit pricing.
Multi-bank financings are particularly vulnerable to repricing, as minority lenders
have considerable leverage over terms. Finally, bankers will be more insistent than
ever that credit relationships be augmented with deposits and other fee-generating,
In spite of the media and political chorus that government capital injections are
intended to reinvigorate lending, the facts are that most banks are limited in their
ability to extend new credit. With solvency still an issue, banks are conserving
capital as they brace for default rates, over the next year, that may well test
historical highs. Most bankers say that the opportunities they are seeing do not
pass muster in this risk-averse world. The rules have fundamentally changed. Borrowers
need to recognize this new reality and plan accordingly.
Given the capital constraints
and a dearth of acceptable
lending opportunities, banks
have little prospect of lending
their way out of this hole.